How Angela Merkel plans to fix Europe

Markets are desperate for clarity on whether Greece will be forced to exit the euro zone or whether Spain and Italy can stop the terrifying rise in bond interest rates.

But one tip is to concentrate on Europe’s most powerful politician, German Chancellor
Angela Merkel
. She has a practical veto on whether to keep Greece in the euro or to bail out Italy and Spain.

So what is Merkel doing?

Well, like everyone else in Europe, “mutti", or mum, as she is affectionately known, is going on holidays. As Spanish bond yields top 7 per cent and Greece begs for mercy from its executioners in the International Monetary Fund and the European Central Bank, Merkel started her summer break by attending the opening of the Bayreuth opera festival.

That in itself shows that Germany perceives the crisis in slightly less urgent terms than the markets. Merkel can probably enjoy the break even more after ECB president Mario Draghi’s hint on Thursday that he was ready to help lower borrowing costs for Spain and Italy.

But Europe is clearly on Merkel’s political agenda. Before she went away, she gave a traditional summer interview to a German television station in which she inevitably was asked about the euro zone crisis. It is clear that she sees this as the crucial issue for the German elections, due in September or October next year – about the same time
Julia Gillard
will head to the polls.

“Next year’s vote will also be about the situation in Europe and what expectations we have for Europe," Merkel said. She and her centre-right coalition have a vision of a European Union as a “stability union that can assert itself on the world stage so we have jobs and so things go well for the people in our country".

Merkel did not sound like she was expecting the euro zone to collapse next year. But note carefully her stress on the idea of a “stability union", which is code in German politics for demanding austerity from other European countries before handing over cash. It is in contrast in the German political debate to a “transfer union," where Germany just pays for everyone else.

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And yet Merkel promises that the euro zone will deliver jobs and growth in Germany.

Merkel has earned a reputation as a dour politician who says “nein" to anything other than austerity. But as her careful answer suggests, she is a very flexible political animal who can surprise, just like her decision to wear a glam off-the-shoulder dress to Bayreuth. She can turn on a pin. When the Greens shot up in the polls after the Fukushima nuclear accident last year, she announced that Germany would close all its nuclear reactors, shocking business and her European partners.

Merkel has just survived a series of crucial diplomatic battles and come out still leading in the opinion polls. While some say she has driven an uncompromising austerity policy, others say she has been a genius at bending enough to keep the euro afloat while being tough enough on Greece to take the German people with her.

Hans-Peter Keitel, head of the BDI, the main German business lobby – and a former chairman of Hochtief, a major shareholder of Australia’s Leightons – told a recent audience in Washington that her European allies and critics alike should stop attacking Merkel. “It’s a very fine line between going forward with the euro and the danger of going back to the population, which in my view is not prepared to follow very fast."

Merkel is caught between two extremes. On one hand, the €2.2 trillion ($2.6 trillion) of loans that the euro zone and the ECB have made or have promised to make to Greece, Italy and the rest is a frightening obligation. Despite its economic strength, Moody’s put Germany’s AAA credit rating on negative outlook in the week because of the potential liabilities if the peripheral countries default. This worries some Germans so Merkel has promised to be tough on her European partners.

But a euro zone collapse may be a body blow for the German economy in the months before the election and thus for Merkel’s re-election chances. This gives the chancellor a big political incentive to kick that can down the road.

So Merkel has had to duck and weave. Her pledge of euro zone austerity is a bit like Gillard’s dilemma over maintaining a virtuous budget surplus. It may become a liability if it results in a recession.

Merkel’s centre-right Christian Democrats are polling at about 35 per cent, compared with 30 per cent for the centre-left Socialist Democrat Party, her main rival.

Her problem is that support has collapsed for her traditional coalition partner, the Free Democrat Party, a small l liberal group. Merkel is unlikely to be able to form a government with the current coalition after the next election. A strong showing in the vote next year will at best allow her to dictate terms in the coalition talks with the centre-left SDP or the Greens, which poll 30 per cent and 15 per cent respectively.

A month ago, Merkel made a few concessions to the anti-austerity camp. With the SDP and Greens warning that her policies would destroy the euro-zone economy, and with early signs of a slowdown in Germany, she took up an SDP proposal for some euro zone-funded job creation programs.

When confronted by a united bloc of France, Spain and Italy at a European summit in June that demanded slightly less austerity, Merkel agreed to a deal where all the European countries might eventually share the liability for Spain and Ireland’s troubled banks.

But she has had to duck the other way in the past few weeks to avoid looking too soft. A growing group of MPs in Merkel’s own coalition, a mixture of right-wing free marketers and
Barnaby Joyce
-like provincial conservatives, have crossed the floor to oppose her small concessions to European partners and the SDP and Greens. Last week Merkel, who ordinarily has a comfortable majority, had to rely on votes from the SDP and Greens to pass the bill that authorised a €100 billion loan to Spain to clean up its banks.

Merkel’s task has been made harder by Germany’s constitutional court, which has decided that the parliament must vote on each and every bailout payment to each country, rather than just approving a maximum borrowing limit and leaving it up to bureaucrats to decide the details. As a result, Merkel is faced with a make-or-break vote in parliament almost every month.

Indeed, the constitutional court is due to rule on September 12 on the legality of the European Stability Mechanism, an expanded €600 billion bailout fund that will be needed if things go badly wrong.

It is very unlikely that Merkel will be dumped by her party. After being forced to rely on SDP and Green votes for the Spanish bailout, she said: “We always get the majorities we need." But relying on opposition support for her European policy leaves Merkel vulnerable. A political crisis may develop next year over whether Spain will be allowed to repackage the €100 billion loan it has received for its bank bailouts and shift the burden to the ESM.

Bank bashing is a popular idea in Germany and a weak point for Merkel, who spent tens of billions of euros in the global financial crisis bailing out Germany’s banks. The SDP may make it sound like aid for Spanish banks is Merkel once again helping out her fat-cat mates.

“There will be no direct way from the rescue package for Spanish banks to a permanent recapitalisation of distressed banks – not with the Social Democrats," said Frank-Walter Steinmeier, the likely Social Democrat rival to Merkel.

This political in-fighting is denting the once strong pro-European consensus in Germany. Some polls say a majority of voters are against the euro even though all major parties want to keep it. Others suggest there is still a majority in favour of helping European countries, provided tough conditions are attached.

Merkel will be hoping that some of the tension can be taken out of these debates in coming months and that the economy holds up.

It is very hard to see Merkel winning parliamentary support for more cash for Greece, which is seen as a chronic deadbeat. But a Greek default will crystallise Germany’s losses on the loans it and the ECB have already made.

Over the northern summer, independent auditors will release final estimates of exactly how much the Spanish bank bailout will cost. By September, the Europeans should release a proposal for a banking union, which will guarantee that German regulators can oversee how the money is spent. Those two elements may allow Merkel to build a coalition for her bailout for Spain.

An endorsement of the ESM bailout funds by the constitutional court may calm nerves in Germany, where the court is sacrosanct. Merkel is relying on all that to help her duck and weave until next year’s elections.